A practical guide on accounting for share awards

Why are share options frequently used as incentives? 

Using share options as a means of remunerating key staff has several benefits, not least because of the way they are structured. 

A share option, in simple terms, gives the holder of the option the right (but not the obligation) to acquire a share in a company at a predetermined price (its “exercise price”). The holder of a share option is protected from falling share prices in this way, as they can choose not to exercise their option should they find that their option is ‘out of the money’. On the other hand, if the share price rises above the exercise price (and any other conditions set out in the options have been met), then the option holder will benefit from a net gain equal to the value of the acquired share, less the exercise price paid to acquire it. 

This pay-off structure means that management can be given a greater incentive than if they had been issued a straightforward interest in shares. The logic for this is that, if a manager is awarded shares and the company are targeting a 10% level of growth in the business, achieving such a gain for that manager will only be 10% of their total award. However, if they are issued options with an exercise price equal to the current share value, then 100% of their award will be attached to growing the business. 

Alongside this, share options may present various tax advantages. Again, because share options provide a future benefit that is contingent on performance, the ‘present value’ (or value in today’s terms) of those awards will be lower than an award of straightforward shares. Further, HMRC allow for additional tax advantages under certain schemes, such as the Company Share Option Plan (CSOP) or Enterprise Management Incentives (EMI) schemes. 

How do these get reported in company financial statements? 

The ‘fair value’ (or market value – being the price at which two hypothetical parties would transact in an arm’s length deal) as at the award date needs to be determined first (albeit noting here that, if the options are ‘cash-settled’ rather than settled in share instruments, the accounting treatment will differ: for brevity, and as by far the majority of awards are equity-settled, we do not cover cash-settled awards here). 

If the award has been made in exchange for goods and services – the value of which can be reliably measured (which cannot apply to awards made as remuneration) – then the value of those goods and services is recognised. Failing that, and unless the shares or share options awarded are themselves quoted on an ‘active market’ (such as the London Stock Exchange), then a valuation method will most likely need to be used. This will only need to be done at issue date. 

We have previously covered share valuation approaches here, and the valuation of the shares which can be acquired under option will also be a necessary step in the valuation of those options.  

The option valuation itself should typically be performed using a specific option-pricing methodology such as the Black-Scholes method, a ‘lattice’ (binomial / trinomial) approach, or a Monte Carlo simulation. Such methods consider the current share value and the exercise price, the likely time to exercise, and how volatile the share price is likely to be (amongst other things) to assess the present value of options. It is important to note that, even if an option is ‘out of the money’ currently, there remains a ‘hope value’ so long as there is enough time for this situation to change. 

Also taken into account in valuing the options are any “market-based performance conditions” i.e. terms which must be met before the option may be allowed to exercise, or ‘vest’, that are tied in to share price performance. 

Calculating the annual charge  

Once the options have been valued, then a charge must be calculated for the income statement. On the face of it, this sounds straightforward – as instinctively the total charge should be equivalent to the option value multiplied by the number of options. 

However, under reporting standards the charge should be spread across the ‘vesting period’. Typically, particularly with employee share option schemes, there is a period of service that is expected before the options can be exercised. Reporting standards take the view that this period of service aligns with the period over which the deemed ‘cost’ (in this case, of employment) is being incurred – and so the charge is spread accordingly. 

A second adjustment here arises from ‘non-market’ performance conditions. An obvious one is the service period itself – if an employee leaves during the vesting period, then they forfeit the right to acquire shares – meaning that the charge essentially never gets incurred for that individual. There may also be other conditions – for example revenue or profit targets – which must be achieved before the options may be allowed to vest. 

In this instance, unlike market-based conditions which, as mentioned above, impact the option value, the charge to the income statement is amended with reference to the number of options that are expected to vest. Over the vesting period, this charge is then allowed to ‘true-up’ for changes in this expectation, as well as ultimately the number of options which do vest. 

Conclusion

Although issues of shares and share options may be viewed simply as ‘paper’ transactions, they reflect a genuine expense, which must be accounted for accordingly. This generates questions as to how such an expense should be quantified, and recognised over time, with numerous factors that must be navigated. 

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